The Unkindest Cuts

Perhaps the biggest issue going into the fall’s midterm elections is the elimination, extension or modification of the so-called Bush tax cuts. It affects our wallets, of course, but also our nation’s financial future, as government debt continues to expand to immense proportions While the argument is sometimes framed as tax cuts for the rich, the truth is if Congress does nothing before January, virtually all Americans’ paychecks would shrink.

The tax cuts passed under the Bush administration, mostly enacted in 2001 and 2003, substantially lowered what every taxpayer, poor and rich, owes each year. Among the dozen major tax changes, the single biggest provision was a new 10% bracket for the first several thousand dollars we earn, which benefited all taxpayers, including low-income households who also received bigger refundable credits. Middle-income households got marriage penalty relief, and when the per-child tax credit doubled from $500 to $1,000, they got most of the benefit.

High-income households got their full itemized deductions back and estate tax relief, and investors got a lower rate on capital gains and dividends. Across the board, the marginal tax rates on wages fell from 28%, 31%, 36% and 39.6% to 25%, 28%, 33%, and 35%. In short, virtually every American’s paycheck got bigger.

If the tax cuts were to fully expire, New Yorkers would be among the hardest hit, since their incomes are higher. For example, the average middle-income family in Carolyn Maloney’s congressional district (NY-14) would face income taxes that are $3,066 higher.

The tax cuts were all temporary because Republicans could not get enough Democratic votes to gain a 60-vote Senate majority. Without that supermajority, no bill can pass if it adds to the deficit for more than 10 years. Well, the 10 years have passed, and it’s a different world. Instead of budget surpluses on the horizon, a looming fiscal cliff is much closer than anyone would have thought possible. Extending the Bush tax cuts in full for another 10 years would add an estimated $3 trillion to the national debt. That is on top of the $8 trillion that is already set to be added to the debt under the president’s proposed budget for 2011-20.

Tax cuts from the Bush years aren’t the only tax laws set to expire on Dec. 31. President Obama’s stimulus bill included temporary tax credits for higher education, more refundable tax credits for low-income households, and a new “making work pay” tax credit worth $400 per worker – those are expiring, too.

So what can we expect Washington to do before Jan. 1?

There is a chance that Congress will take no action and allow all of the tax cuts to expire. Most experts were shocked in 2009 when Congress did nothing to stop a scheduled repeal of the estate tax, so a similar scenario could play out this fall. And full expiration has academic support from renowned economists Alan Blinder and Alan Greenspan, who say a commitment to fiscal responsibility is worth any short-term economic harm.

But that is not the Democrats’ plan. Instead, they propose extending about 80% of the Bush tax cuts. Only high-income taxpayers, defined as single people earning more than $200,000 and couples earning more than $250,000, will see their paychecks shrink in January. That threshold was set by then-candidate Obama on the 2008 campaign trail.

High-income people will lose many of their tax cuts under the Democrats’ plan: they’ll lose a large fraction of their itemized deductions including charitable gifts and mortgage interest. Their tax rate on qualified dividends and long-term capital gains will go from 15% to 20%, and the top two wage tax rates will return to 36% and 39.6% from their current levels of 33% and 35%. According to the administration, these restored higher tax levels would raise about $630 billion over 10 years, which is about only one-fifth of the $3 trillion price tag for making all the tax cuts permanent. In his budget, President Obama proposed cutting back further on the itemized deductions of high-income taxpayers, but Congress has ignored that idea for the second year in a row.

On the other end of the policy option spectrum is full extension of the tax cuts, which most Republicans favor. With a weak recovery faltering, they argue, higher tax rates on everyone would be disastrous, and even if limited to high-income people, the job-creating business sector would suffer. As for the benefit of deficit reduction cited by Blinder and Greenspan, Republicans scoff, predicting that government would just spend the additional revenue instead of paying down debt.

And the fate of the Bush tax cuts is not the only uncertainty. What will Congress do about the tax credits in the stimulus bill, worth about $70 billion per year? President Obama proposes extending all of them at least one year and some permanently. But when House Democrats recently publicized a tax plan officially scored by the Joint Committee on Taxation, none of the major Obama stimulus credits were included.

Over the next four months, Congress will be making the first of what will be many major decisions over the next decade concerning the future of US fiscal policy. So when the champagne corks pop 130 days from now on New Year’s Day, what tax rates will each of us be paying?

Gerald Prante is senior economist at the Tax Foundation, a nonprofit, nonpartisan research and educational organization that monitors fiscal policy.

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